Credit rating downgrade risk and acquisition decisions

Abstract

This study examines the impact of credit rating downgrade risk on acquisition decisions. I find that firms at risk of a rating downgrade conduct fewer acquisitions. This result is robust to different measures of downgrade risk, instrumental variable analyses and matched sample tests. The correlation between downgrade risk and acquisitionpropensity is likely driven by the concern that risks associated with acquisitions lead to downgrades as evidenced by the more cautious approach of acquirers facing downgrade risk. These firms take more time to complete deals, hire more and higher-quality financial advisors, issue less debt to finance merger consideration, adopt target termination fee clauses and select targets with lower information asymmetry and higher ratings. This more cautious approach is associated with better long-term post-merger performance and reduced future-downgrade risk. Subgroup analyses reveal credit rating downgrade risk is negatively associated with acquisition decisions and positively associated with performance for investment-grade firms, especially BBB-firms, which are on the brink of being downgraded to non-investment grade. Such associations are not significant for non-investment-grade firms. Overall, the results suggest that firms at risk of a rating downgrade conduct acquisitions more cautiously, leading to fewer but more value-creating deals.